-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, E7vkfSZ+WweNTxzWatgHN5h0r3xpQs2vvRMXCkhP1wnnVMJvkis62jQUxgY6a3Zt ZZKoTtMI6/LSdgxsqBa5kA== 0000110764-06-000003.txt : 20060616 0000110764-06-000003.hdr.sgml : 20060616 20060616084250 ACCESSION NUMBER: 0000110764-06-000003 CONFORMED SUBMISSION TYPE: N-30B-2 PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060616 DATE AS OF CHANGE: 20060616 EFFECTIVENESS DATE: 20060616 FILER: COMPANY DATA: COMPANY CONFORMED NAME: WASHINGTON NATIONAL VARIABLE ANNUITY FUND B CENTRAL INDEX KEY: 0000110764 IRS NUMBER: 361933760 STATE OF INCORPORATION: IL FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: N-30B-2 SEC ACT: 1940 Act SEC FILE NUMBER: 811-01662 FILM NUMBER: 06908583 BUSINESS ADDRESS: STREET 1: ONE PRESIDENTIAL PARKWAY CITY: KOKOMO STATE: IL ZIP: 46904 BUSINESS PHONE: 7654530602 MAIL ADDRESS: STREET 1: ONE PRESIDENTIAL PARKWAY CITY: KOKOMO STATE: IL ZIP: 46904 N-30B-2 1 wnicb.txt WASHINGTON NATIONAL (B) June 16, 2006 Dear Contract Holder: Attached are the December 31, 2005 audited financial statements of Washington National Insurance Company. We appreciate and value your business, and look forward to serving you again in the future. Sincerely, Washington National Insurance Company The March 1, 2006 Fundamental Investors, Inc. Prospectus, file number 811-00032, as filed with the Securities and Exchange Commission on February 28, 2006 is incorporated herein by reference. Washington National Insurance Company Consolidated Financial Statements: - as of December 31, 2005 and 2004 and for the years ended December 31, 2005 and 2004 and four months ended December 31, 2003 (Successor Company) - for the eight months ended August 31, 2003 (Predecessor Company) Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholder Washington National Insurance Company: In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, shareholder's equity and cash flows present fairly, in all material respects, the financial position of Washington National Insurance Company and subsidiaries (Successor Company) at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005 and for the period from September 1, 2003 through December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements give retroactive effect to certain business combination transactions as described in Notes 1 and 4 to the consolidated financial statements. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Conseco, Inc. is the ultimate parent of Washington National Insurance Company. As discussed in Note 2 to the consolidated financial statements, the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division confirmed Conseco, Inc.'s Sixth Amended Joint Plan of Reorganization (the "Plan") on September 9, 2003. The provisions of the Plan are described in detail in Note 2. The Plan was substantially consummated on September 10, 2003 and Conseco, Inc. emerged from bankruptcy. In connection with its emergence from bankruptcy, the Company adopted fresh start accounting as of August 31, 2003. /s/PricewaterhouseCoopers LLP - ----------------------------- Indianapolis, Indiana May 8, 2006 2 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholder Washington National Insurance Company In our opinion, the accompanying consolidated statements of operations, shareholder's equity and cash flows present fairly, in all material respects, the results of operations and cash flows of Washington National Insurance Company and subsidiaries (the Predecessor Company) for the period from January 1, 2003 through August 31, 2003 in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements give retroactive effect to certain business combination transactions as described in Notes 1 and 4 to the consolidated financial statements. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Conseco, Inc. is the ultimate parent of Washington National Insurance Company. As discussed in Note 2 to the consolidated financial statements, Conseco, Inc. filed a petition on December 17, 2002 with the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division for reorganization under the provisions of Chapter 11 of the Bankruptcy Code. Conseco, Inc.'s Sixth Amended Joint Plan of Reorganization (the "Plan") was substantially consummated on September 10, 2003 and Conseco, Inc. emerged from bankruptcy. In connection with the emergence from bankruptcy, the Company adopted fresh start accounting as of August 31, 2003. /s/PricewaterhouseCoopers LLP - ----------------------------- Indianapolis, Indiana March 10, 2004 3 WASHINGTON NATIONAL INSURANCE COMPANY CONSOLIDATED BALANCE SHEET December 31, 2005 and 2004 (Dollars in millions) ASSETS
Successor ----------------- 2005 2004 ---- ---- Investments: Actively managed fixed maturities at fair value (amortized cost: 2005 - $8,634.7; 2004 - $8,671.3)........................................................ $ 8,680.5 $ 8,925.7 Preferred stock of affiliates at fair value................................................. 58.6 59.5 Mortgage loans.............................................................................. 529.8 531.3 Policy loans................................................................................ 367.1 387.1 Trading securities.......................................................................... 420.2 587.2 Other invested assets ...................................................................... 79.9 107.9 --------- --------- Total investments..................................................................... 10,136.1 10,598.7 Cash and cash equivalents....................................................................... 42.8 408.2 Accrued investment income....................................................................... 139.1 144.5 Value of policies in force at the Effective Date................................................ 795.1 877.0 Cost of policies produced....................................................................... 100.4 34.3 Reinsurance receivables......................................................................... 351.2 433.5 Income tax assets............................................................................... 164.9 152.1 Assets held in separate accounts................................................................ 29.8 32.9 Other assets.................................................................................... 183.9 193.7 --------- --------- Total assets.......................................................................... $11,943.3 $12,874.9 ========= =========
(continued on next page) The accompanying notes are an integral part of the consolidated financial statements. 4 WASHINGTON NATIONAL INSURANCE COMPANY CONSOLIDATED BALANCE SHEET (Continued) December 31, 2005 and 2004 (Dollars in millions, except per share amount) LIABILITIES AND SHAREHOLDER'S EQUITY
Successor ----------------- 2005 2004 ---- ---- Liabilities: Insurance liabilities..................................................................... $10,191.2 $10,729.2 Liabilities related to separate accounts.................................................. 29.8 32.9 Investment borrowings..................................................................... 12.9 310.7 Other liabilities......................................................................... 149.5 136.0 --------- --------- Total liabilities................................................................... 10,383.4 11,208.8 --------- --------- Commitments and contingencies (Note 8) Shareholder's equity: Common stock and additional paid-in capital (par value $5.00 per share, 5,250,000 shares authorized, 5,007,370 shares issued and outstanding)............................ 1,574.6 1,540.3 Accumulated other comprehensive income.................................................... 38.0 165.7 Accumulated deficit....................................................................... (52.7) (39.9) --------- --------- Total shareholder's equity.......................................................... 1,559.9 1,666.1 --------- --------- Total liabilities and shareholder's equity.......................................... $11,943.3 $12,874.9 ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 5 WASHINGTON NATIONAL INSURANCE COMPANY CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in millions)
Successor Predecessor -------------------------------------- ------------- Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003(a) 2003(a) ---- ---- ---- ---- Revenues: Insurance policy income................................. $ 696.7 $ 751.4 $264.4 $ 638.4 Net investment income................................... 572.8 610.8 250.1 506.0 Net realized investment gains (losses).................. (2.6) 51.0 6.6 (4.6) Other .................................................. 12.0 15.3 4.3 9.7 -------- -------- ------ --------- Total revenues...................................... 1,278.9 1,428.5 525.4 1,149.5 -------- -------- ------ --------- Benefits and expenses: Insurance policy benefits............................... 803.8 895.7 332.7 547.5 Amortization ........................................... 129.2 129.2 53.9 153.8 Other operating costs and expenses...................... 238.1 251.6 96.8 175.3 Reorganization items.................................... - - - 1,332.1 -------- -------- ------ --------- Total benefits and expenses......................... 1,171.1 1,276.5 483.4 2,208.7 -------- -------- ------ --------- Income (loss) before income taxes................... 107.8 152.0 42.0 (1,059.2) Income tax expense (benefit) on period income.............. 35.6 41.9 15.0 (28.1) -------- -------- ------ --------- Net income (loss)................................... $ 72.2 $ 110.1 $ 27.0 $(1,031.1) ======== ======== ====== ========= - ---------- (a) Restated to give retroactive effect for a business combination transaction. See notes 1 and 4 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements. 6 WASHINGTON NATIONAL INSURANCE COMPANY CONSOLIDATED STATEMENT OF SHAREHOLDER'S EQUITY(a) (Dollars in millions)
Common stock Accumulated other and additional comprehensive Total paid-in capital income (loss) Accumulated deficit ----- --------------- ------------- ------------------- Predecessor balance, December 31, 2002.................... $ 2,418.0 $ 3,481.7 $ 82.4 $(1,146.1) Comprehensive loss, net of tax: Net loss............................................. (1,031.1) - - (1,031.1) Change in unrealized appreciation of investments (net of applicable income tax benefit of nil)......................... (15.5) - (15.5) - --------- Total comprehensive loss......................... (1,046.6) Capital contribution................................... 28.6 28.6 - - --------- --------- ------- --------- Predecessor balance, August 31, 2003...................... 1,400.0 3,510.3 66.9 (2,177.2) Fresh start adjustments................................... - (2,110.3) (66.9) 2,177.2 --------- --------- ------- --------- Successor balance, August 31, 2003........................ 1,400.0 1,400.0 - - Comprehensive income, net of tax: Net income........................................... 27.0 - - 27.0 Change in unrealized appreciation of investments (net of applicable income tax expense of $44.7)....................... 144.7 - 144.7 - --------- Total comprehensive income....................... 171.7 Dividends on common stock.............................. (70.0) - - (70.0) --------- --------- ------- --------- Successor balance, December 31, 2003...................... 1,501.7 1,400.0 144.7 (43.0) Comprehensive income, net of tax: Net income........................................... 110.1 - - 110.1 Change in unrealized appreciation of investments (net of applicable income tax expense of $11.2)....................... 21.0 - 21.0 - --------- Total comprehensive income....................... 131.1 Capital contribution................................... 50.0 50.0 - - Reduction of deferred income tax valuation allowance... 90.3 90.3 - - Dividends on common stock.............................. (107.0) - - (107.0) --------- --------- ------- --------- Successor balance, December 31, 2004...................... 1,666.1 1,540.3 165.7 (39.9) Comprehensive loss, net of tax: Net income........................................... 72.2 - - 72.2 Change in unrealized appreciation of investments (net of applicable income tax benefit of $35.1)....................... (127.7) - (127.7) - --------- Total comprehensive loss......................... (55.5) Reduction of deferred income tax valuation allowance... 33.3 33.3 - - Net transfer of investments to affiliates.............. 1.0 1.0 - - Dividends on common stock.............................. (85.0) - - (85.0) --------- --------- ------- --------- Successor balance, December 31, 2005...................... $ 1,559.9 $ 1,574.6 $ 38.0 $ (52.7) ========= ========= ======= ========= - ---------- (a) Amounts presented through December 31, 2003 have been restated to give retroactive effect for a business combination transaction. See notes 1 and 4 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements. 7 WASHINGTON NATIONAL INSURANCE COMPANY CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in millions)
Successor Predecessor -------------------------------------- ------------ Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003(a) 2003(a) ---- ---- ---- ---- Cash flows from operating activities: Net income (loss).................................... $ 72.2 $ 110.1 $ 27.0 $(1,031.1) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Amortization and depreciation.................... 142.9 145.1 60.2 167.8 Income taxes..................................... 55.6 68.9 109.8 (5.8) Insurance liabilities............................ (75.7) 27.5 30.5 (220.7) Accrual and amortization of investment income.... 71.6 128.1 31.6 37.1 Deferral of policy acquisition costs............. (35.4) (27.8) (14.3) (40.8) Net (gains) losses from sales of investments..... 2.6 (51.0) (6.6) 4.6 Reorganization items............................. - - - 1,332.1 Net sales of trading securities.................. 152.1 12.3 49.6 - Other............................................ 100.7 (57.7) 4.7 (.6) --------- --------- --------- --------- Net cash provided by operating activities.... 486.6 355.5 292.5 242.6 --------- --------- --------- --------- Cash flows from investing activities: Sales of investments................................. 6,148.0 6,848.0 2,062.5 1,974.8 Maturities and redemptions........................... 680.2 1,002.3 564.6 928.5 Purchases of investments............................. (6,784.3) (7,657.1) (2,534.3) (2,115.5) Other................................................ (22.3) (42.9) (3.7) (34.3) --------- --------- --------- --------- Net cash provided by investing activities.... 21.6 150.3 89.1 753.5 --------- --------- --------- --------- Cash flows from financing activities: Capital contribution................................. - - - 28.6 Deposits to insurance liabilities.................... 706.5 662.8 211.9 528.5 Investment borrowings................................ (297.7) 19.5 (9.0) (100.2) Withdrawals from insurance liabilities............... (1,197.4) (1,320.2) (449.0) (1,478.9) Dividends paid on common stock....................... (85.0) (90.0) (52.3) (45.0) --------- --------- --------- --------- Net cash used by financing activities........ (873.6) (727.9) (298.4) (1,067.0) --------- --------- --------- --------- Net increase (decrease) in cash and cash equivalents.......................... (365.4) (222.1) 83.2 (70.9) Cash and cash equivalents, beginning of period.......... 408.2 630.3 547.1 618.0 --------- --------- --------- --------- Cash and cash equivalents, end of period................ $ 42.8 $ 408.2 $ 630.3 $ 547.1 ========= ========= ========= ========= - --------- (a) Restated to give retroactive effect for a business combination transaction. See notes 1 and 4 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements. 8 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 1. BASIS OF PRESENTATION Washington National Insurance Company ("Washington National") and its wholly owned subsidiaries, Conseco Insurance Company ("CIC") and Conseco Life Insurance Company ("Conseco Life") (collectively "we" or the "Company") are life insurance companies domiciled in Illinois, Illinois and Indiana, respectively, which develop, market and administer annuity, individual life insurance, individual and group accident and health insurance and other insurance products. The Company is an indirect wholly owned subsidiary of Conseco, Inc., a Delaware corporation ("Conseco"). Conseco is a financial services holding company with subsidiaries operating throughout the United States. The consolidated financial statements include the following companies: - Washington National; - Conseco Life; - Bankers National Life Insurance Company ("BNL", an indirect wholly owned subsidiary of Conseco) which was merged into the Company effective October 1, 2004; - CIC (formerly Conseco Annuity Assurance Company prior to its name change in March 2004), an indirect wholly owned subsidiary of Conseco, whom Conseco contributed 100 percent of the outstanding common stock to the Company on December 26, 2003; and - Pioneer Life Insurance Company ("Pioneer Life", an indirect wholly owned subsidiary of Conseco) which was merged into the Company on July 1, 2003. The consolidated financial statements also include Pioneer Life's wholly owned subsidiary, Conseco Medical Insurance Company. The mergers and contributions described above were accounted for similar to a pooling of interests because all of the companies are under common control of Conseco. Therefore, the assets and liabilities of each company were combined at their book values and the consolidated statements of operations, shareholder's equity and cash flows have been restated for all periods presented as if the companies had always been combined. Intercompany transactions among the consolidated companies have been eliminated in consolidation. We have reclassified certain amounts in our 2004 and 2003 consolidated financial statements and notes to conform with the 2005 presentation. These reclassifications have no effect on net income or shareholder's equity. 9 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 2. FRESH START REPORTING On December 17, 2002, Conseco's predecessor, Conseco, Inc., an Indiana corporation ("Old Conseco", the Company's former ultimate parent), CIHC, Inc. ("CIHC", a wholly owned subsidiary of Old Conseco) and certain of their subsidiaries (collectively referred to as the "Debtors") excluding the Company, filed petitions for reorganization under Chapter 11 of Title 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Illinois (the "Bankruptcy Court"). Effective September 10, 2003 (the "Effective Date"), the Debtors emerged from bankruptcy protection under the Plan of Reorganization, which was confirmed pursuant to an order of the Bankruptcy Court on September 9, 2003 (the "Plan"). In accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code," ("SOP 90-7"), the Company, as a subsidiary of Conseco, adopted fresh start accounting on the Effective Date. Our accounting and actuarial systems and procedures are designed to produce financial information as of the end of a month. Accordingly, for accounting convenience purposes, the effects of fresh start accounting were reported as if they occurred on August 31, 2003. References in the financial statements to "Predecessor" refer to the Company prior to August 31, 2003. References to "Successor" refer to the Company on and after August 31, 2003, after giving effect to the implementation of fresh start accounting. 10 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Under fresh start accounting, a new reporting entity was considered to be created and the Company was required to revalue its assets and liabilities at current estimated fair values, re-establish shareholder's equity at the reorganization value pursuant to the Plan, and record the excess of the reorganization value over specific tangible or identified intangible assets as goodwill. As a result, the Company's financial statements for periods following August 31, 2003, are not comparable to those prepared before that date. In addition, all accounting standards that were required to be adopted in the financial statements within twelve months following the adoption of fresh start accounting were adopted as of August 31, 2003. The following table presents the adjustments made to the Predecessor's consolidated balance sheet to reflect the change in capital structure and the fair values of assets and liabilities as of August 31, 2003 (dollars in millions):
Fresh Predecessor start Successor balance sheet(a) adjustments balance sheet ---------------- ----------- ------------- Assets: Investments ............................................................. $11,709.6 $ (896.8) (b) $10,812.8 Cash and cash equivalents................................................ 547.0 - 547.0 Accrued investment income................................................ 206.9 (54.6) (d) 152.3 Value of policies in force at the Effective Date......................... - 1,072.7 (c) 1,072.7 Cost of policies purchased............................................... 580.1 (580.1) (c) - Cost of policies produced................................................ 660.1 (660.1) (c) - Reinsurance receivables.................................................. 377.0 4.0 (d) 381.0 Goodwill................................................................. - 235.5 (d) 235.5 Other intangible assets.................................................. - 9.9 (d) 9.9 Income tax assets........................................................ 51.2 - 51.2 Assets held in separate accounts......................................... 37.8 - 37.8 Other assets............................................................. 290.0 4.9 (d) 294.9 --------- --------- --------- Total assets........................................................ $14,459.7 $ (864.6) $13,595.1 ========= ========= ========= Liabilities: Insurance liabilities and liabilities related to separate accounts....... $11,007.9 $ 507.4 (e) $11,515.3 Other liabilities........................................................ 369.5 (39.9) (d) 329.6 Investment borrowings.................................................... 300.2 - 300.2 Surplus debenture payable to parent...................................... 50.0 - 50.0 --------- --------- --------- Total liabilities ................................................. 11,727.6 467.5 12,195.1 --------- --------- --------- Shareholder's equity: Common stock and additional paid-in capital.............................. 3,510.3 (2,110.3) 1,400.0 Accumulated deficit...................................................... (845.1) 845.1 - Accumulated other comprehensive income................................... 66.9 (66.9) - --------- --------- --------- Total shareholder's equity.......................................... 2,732.1 (1,332.1) 1,400.0 --------- --------- --------- Total liabilities and shareholder's equity................................... $14,459.7 $ (864.6) $13,595.1 ========= ========= =========
11 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- - ----------------- (a) Predecessor balance sheet as of August 31, 2003, prior to the fresh start adjustments. (b) The values of our mortgage loans, policy loans, other invested assets and preferred stock of affiliates were adjusted to market value at the Effective Date. In addition, the cost basis of our actively managed fixed maturities was increased to the market value at the Effective Date. (c) The Company's historical cost of policies purchased and cost of policies produced were eliminated and replaced with the value of policies in force at the Effective Date. The value of policies in force reflected the estimated fair value of the Company's business inforce and represents the value of the right to receive future cash flows from the policies in force on the Effective Date. The value of policies in force was determined using a discount rate of 12 percent, which was the rate of return that our management (with assistance from a consulting actuarial firm) believed would be required by a purchaser of the business, based on conditions existing as of the Effective Date. In determining such rate of return, the following factors, among others, were considered: * The magnitude of the risks associated with each of the actuarial assumptions used in determining the expected cash flows; * Market rates of interest that would be applicable to an acquisition of the business; * The perceived likelihood of changes in insurance regulations and tax laws; * The complexity of the business; and * Prices paid for similar blocks of business. (d) Assets and liabilities were adjusted to reflect their estimated fair market values. The portion of the reorganization value that could not be attributed to specific tangible or identified intangible assets was recorded as goodwill. (e) The Company establishes reserves for insurance policy benefits based on assumptions as to investment yields, mortality, morbidity, withdrawals and lapses. These reserves include amounts for the estimated future payments of claims based on actuarial assumptions. Many factors can affect these reserves, such as economic conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra contractual damage awards. The fresh-start balance was based on the Company's best estimate (with assistance from a consulting actuarial firm) of the future performance of this business, given recent and expected future changes in experience. Adjustments to the Predecessor's liabilities for insurance products are further discussed in the note to the consolidated financial statements entitled "Liabilities for Insurance Products". 12 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 3. SIGNIFICANT ACCOUNTING POLICIES The following summary explains the significant accounting policies we use to prepare our financial statements. We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). We follow the accounting standards established by the Financial Accounting Standards Board ("FASB"), the American Institute of Certified Public Accountants and the Securities and Exchange Commission. Investments We classify our fixed maturity securities into one of three categories: (i) "actively managed" (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholder's equity); (ii) "trading" (which we carry at estimated fair value with changes in such value recognized as trading income); or (iii) "held to maturity" (which we carry at amortized cost). We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements. Equity securities include investments in common stock and non-redeemable preferred stock. We carry these investments at estimated fair value. We record any unrealized gain or loss, net of tax and related adjustments, as a component of shareholder's equity. When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations. Equity securities are included in other invested assets. Preferred stock of affiliates are carried at estimated fair value. We record any unrealized gain or loss, net of income taxes, as a component of shareholder's equity. Mortgage loans held in our investment portfolio are carried at amortized unpaid balances, net of provisions for estimated losses. Policy loans are stated at current unpaid principal balances. Our trading securities are designed to act as hedges for embedded derivatives related to our equity-indexed annuity products and certain modified coinsurance agreements. See the note entitled "Accounting for Derivatives" for further discussion regarding embedded derivatives and the trading accounts. In addition, the trading account includes investments backing the market strategies of our multibucket annuity products. The change in market value of these securities, which is recognized currently in investment income, is substantially offset by the change in insurance policy benefits for these products. Our trading securities totaled $420.2 million and $587.2 million at December 31, 2005 and 2004, respectively. Other invested assets include: (i) certain call options purchased in an effort to hedge the effects of certain policyholder benefits; (ii) certain non-traditional investments; and (iii) equity securities. We carry the call options at estimated fair value as further described below under "Accounting for Derivatives". Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method. We defer any fees received or costs incurred when we originate investments. We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments. We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities. When we sell a security (other than trading securities), we report the difference between the sale proceeds and amortized cost (determined based on specific identification) as a realized investment gain or loss. We regularly evaluate all of our investments based on current economic conditions, credit loss experience and other investee-specific developments. When we conclude that a decline in a security's fair value is other than temporary, we treat it as a realized investment loss and reduce our cost basis of the security to its estimated fair value. 13 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Cash and Cash Equivalents Cash and cash equivalents include commercial paper, invested cash and other investments purchased with original maturities of less than three months. We carry them at amortized cost, which approximates estimated fair value. Assets Held in Separate Accounts Separate accounts are funds on which investment income and gains or losses accrue directly to certain policyholders. The assets of these accounts are legally segregated. They are not subject to the claims that may arise out of any other business of the Company. We report separate account assets at market value; the underlying investment risks are assumed by the contractholders. We record the related liabilities at amounts equal to the separate account assets. We record the fees earned for administrative and contractholder services performed for the separate accounts in insurance policy income. Value of Policies Inforce at the Effective Date Upon the implementation of fresh start accounting, we eliminated the historical balances of the Predecessor's cost of policies purchased and cost of policies produced as of August 31, 2003, and replaced them with the value of policies inforce as of the Effective Date, which is the estimated value of the right to receive future cash flows from contracts existing at August 31, 2003. We determined the value of the policies inforce as of the Effective Date using a discount rate of 12 percent, which is described in the note entitled "Fresh Start Reporting". We defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. The balance of this account is amortized, evaluated for recovery, and adjusted for the impact of unrealized gains (losses) in the same manner as described below for the cost of policies produced. The Company expects to amortize the balance of the value of policies inforce at the Effective Date as of December 31, 2005 as follows: 15 percent in 2006, 13 percent in 2007, 11 percent in 2008, 9 percent in 2009 and 7 percent in 2010. Cost of Policies Produced The costs that vary with, and are primarily related to, producing new insurance business subsequent to August 31, 2003 are referred to as the cost of policies produced. For universal life or investment products, we amortize these costs using the interest rate credited to the underlying policies in relation to the estimated gross profits. For other products, we amortize these costs using the projected investment earnings rate in relation to future anticipated premium revenue. When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields. We also adjust the cost of policies produced for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income within shareholder's equity. We regularly evaluate the recoverability of the unamortized balance of the cost of policies produced. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable. If we determine a portion of the unamortized balance is not recoverable, it is charged to amortization expense. 14 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Goodwill The goodwill recognized upon our emergence from bankruptcy resulted from the revaluation of our balance sheet accounts. We revalued our assets and liabilities to current estimated fair value and established our capital accounts at the reorganization value determined in connection with the Plan. We recorded goodwill of $235.5 million representing the excess of the reorganization value over specific tangible or identified intangible assets. In accordance with GAAP, the goodwill balance was not amortized. Pursuant to SOP 90-7, any reduction of the deferred income tax valuation allowance established at the emergence date is accounted for as a reduction of goodwill until goodwill is eliminated. As further described in the note entitled "Income Taxes", the reduction of our deferred income tax valuation allowance resulted in the elimination of our goodwill in 2004. The changes in goodwill were as follows (dollars in millions):
Successor -------------------------------- Year Four months ended ended December 31, December 31, 2004 2003 ---- ---- Goodwill balance, beginning of period................................ $ 106.8 $ 235.5 Reduction of tax valuation allowance established at the Effective Date.................................................. (106.8) (128.7) ------- ------- Goodwill balance, end of period...................................... $ - $ 106.8 ======= =======
Reorganization Items The reorganization items for the eight months ended August 31, 2003, represent the net impact from the implementation of fresh start accounting, as shown in the note entitled "Fresh Start Reporting." Other Intangible Assets Pursuant to SOP 90-7, the reduction of the deferred income tax valuation allowance established at the emergence date is first accounted for as a reduction of goodwill, and second as a reduction of other intangible assets. As further described in the note entitled "Income Taxes", the reduction of a portion of our deferred income tax valuation allowance resulted in the elimination of our other intangible assets in 2004. The other intangible assets identified at the emergence date were valued with assistance from a consulting valuation firm. In accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", other intangible assets with indefinite lives were not amortized and other intangible assets with finite useful lives were amortized over their estimated useful lives. We amortized the value of our independent agency force over 15 years using the straight line method. 15 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- The following summarizes other identifiable intangible assets as of December 31, 2004 (dollars in millions):
Successor --------- 2004 ---- Indefinite lived other intangible assets: State licenses and charters......................................... $ 6.7 ----- Total indefinite lived other intangible assets.................. 6.7 ----- Finite lived other intangible assets: Independent agency force............................................ 3.2 Less accumulated amortization....................................... (.3) ----- Total finite lived other intangible assets...................... 2.9 ----- Reduction of deferred income tax valuation allowance................... (9.6) ----- Total other intangible assets................................... $ - =====
Recognition of Insurance Policy Income and Related Benefits and Expenses on Insurance Contracts For universal life and investment contracts that do not involve significant mortality or morbidity risk, the amounts collected from policyholders are considered deposits and are not included in revenue. Revenues for these contracts consist of charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders' account balances. Such revenues are recognized when the service or coverage is provided, or when the policy is surrendered. We establish liabilities for investment and universal life products equal to the accumulated policy account values, which include an accumulation of deposit payments plus credited interest, less withdrawals and the amounts assessed against the policyholder through the end of the period. Sales inducements provided to the policyholders of these products are recognized as liabilities over the period that the contract must remain in force to qualify for the inducement. The options attributed to the policyholder related to our equity-indexed annuity products are accounted for as embedded derivatives as described in the section of this note entitled "Accounting for Derivatives". Generally, we recognize insurance premiums for traditional life and accident and health contracts as revenues when due from the policyholders. We establish liabilities for traditional life, accident and health insurance, and life contingent payment annuity products using morbidity and mortality tables in general use in the United States, which are modified to reflect the Company's actual experience when appropriate. These reserves are computed at amounts that, with additions from estimated future premiums received and with interest on such reserves at estimated future rates, are expected to be sufficient to meet our obligations under the terms of the policy. Liabilities for future policy benefits are computed on a net-level premium method based upon assumptions as to investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses determined when the policies were issued (or with respect to policies inforce at August 31, 2003, the Company's best estimate of such assumptions on the fresh-start date). Once established, assumptions on these products are generally not changed. We make an additional provision to allow for potential adverse deviation for some of our assumptions. We establish claim reserves based on our estimate of the loss to be incurred on reported claims plus estimates of incurred but unreported claims based on our past experience. 16 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Reinsurance In the normal course of business, we seek to limit our loss exposure on any single insured or to certain groups of policies by ceding reinsurance to other insurance enterprises. We currently retain no more than $.8 million of mortality risk on any one policy. We diversify the risk of reinsurance loss by using a number of reinsurers that have strong claims-paying ratings. In each case, the Company is contingently liable for claims reinsured if the assuming company is unable to pay. The cost of reinsurance is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policies. The cost of reinsurance ceded totaled $105.3 million in 2005; $117.8 million in 2004; $42.8 million in the four months ended December 31, 2003; and $88.7 million in the eight months ended August 31, 2003. We deduct this cost from insurance policy income. Reinsurance recoveries netted against insurance policy benefits totaled $108.4 million in 2005; $143.1 million in 2004; $49.0 million in the four months ended December 31, 2003; and $105.9 million in the eight months ended August 31, 2003. From time-to-time, we assume insurance from other companies. Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize the cost of policies produced described above. Reinsurance premiums assumed totaled $144.9 million in 2005; $159.2 million in 2004; $63.6 million in the four months ended December 31, 2003; and $124.7 million in the eight months ended August 31, 2003. Reinsurance premiums assumed from transactions with affiliates of the Company were $106.8 million in 2005; $116.7 million in 2004; $40.7 million in the four months ended December 31, 2003; and $86.3 million in the eight months ended August 31, 2003. At both December 31, 2005 and 2004, approximately 12 percent of our total reinsurance recoverables were from subsidiaries of Conseco. See "Accounting for Derivatives" for a discussion of the derivative embedded in the payable related to certain modified coinsurance agreements. Income Taxes Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards ("NOLs"). The net deferred tax assets before valuation allowance totaled $494.6 million at December 31, 2005. In evaluating our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire. Based upon information existing at the time of our emergence from bankruptcy, we established a valuation allowance against our entire balance of net deferred income tax assets as we believed that the realization of such net deferred income tax assets in future periods was uncertain. During 2004 and 2005, we concluded that it was no longer necessary to maintain certain portions of the previously established valuation allowance. Accordingly, we reduced our valuation allowance by $206.7 million in 2004 and $36.8 million in 2005. However, we are required to continue to record a valuation allowance of $332.8 million because we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized. This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations or interpretations on the value of such component to be fully recognized in the future. 17 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Investment Borrowings As part of our investment strategy, we may enter into repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateralized borrowings, whereby the amount borrowed is equal to the sales price of the underlying securities. Repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to repurchase agreements except that, with dollar rolls, the repurchase involves securities that are substantially the same as the securities sold (rather than being the same security). Such borrowings averaged $160.0 million during 2005 and $330.0 million during 2004. These borrowings were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on such borrowings was 3.1 percent during 2005 and 1.5 percent during 2004. The primary risk associated with short-term collateralized borrowings is that a counterparty will be unable to perform under the terms of the contract. Exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments. During the third quarter of 2005, the market spread on these transactions declined to a level at which our continued participation in these transactions was not profitable. As a result, these transactions were terminated. Accounting for Derivatives Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return that is based on a percentage (the "participation rate") of a particular index, such as the Standard & Poor's 500 Index, over an annual period. At the beginning of each policy year, a new index period begins. We are able to change the participation rate at the beginning of each index period, subject to contractual minimums. We buy one-year call options on the applicable indices in an effort to hedge potential increases to policyholder benefits resulting from increases in the particular index to which the product's return is linked. We include the cost of the options in the pricing of these products. Policyholder account balances for these annuities fluctuate in relation to changes in the values of these options. We reflect changes in the estimated market value of these options in net investment income. Option costs that are attributable to benefits provided were $34.2 million during 2005; $37.7 million during 2004; $16.2 million during the four months ended December 31, 2003; and $45.8 million during the eight months ended August 31, 2003 and were included in investment income. Net investment income related to equity-indexed products before these option costs were $22.2 million in 2005; $48.8 million in 2004; $51.8 million in the four months ended December 31, 2003; and $71.1 million in the eight months ended August 31, 2003. These amounts were substantially offset by the corresponding charge to insurance policy benefits. The estimated fair value of the options was $34.9 million and $41.7 million at December 31, 2005 and 2004, respectively. We classify these instruments as other invested assets. The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives as defined by Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended by Statement of Financial Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities" (collectively referred to as "SFAS 138"). We record the changes in the fair values of the embedded derivatives in current earnings as a component of insurance policy benefits. The fair value of these derivatives, which are classified as "liabilities for interest-sensitive products", was $182.4 million and $196.9 million at December 31, 2005 and 2004, respectively. We maintain a specific block of investments which are equal to the balance of these liabilities in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income. The change in value of these trading securities should largely offset the portion of the change in the value of the embedded derivative that is caused by interest rate fluctuations. If the counterparties for the derivatives we hold fail to meet their obligations, we may have to recognize a loss. We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy. At December 31, 2005, all of our counterparties were rated "A" or higher by Standard & Poor's Corporation ("S&P"). The FASB's Derivative Implementation Group issued SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Obligor of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific circumstances under which bifurcation of an instrument into a host contract and an embedded 18 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- derivative is required. DIG B36 requires the bifurcation of a derivative from the receivable or payable related to a modified coinsurance agreement, where the yield on the receivable and payable is based on a return of a specified block of assets rather than the creditworthiness of the ceding company. We implemented this guidance on August 31, 2003, in conjunction with our adoption of fresh start accounting. We have determined that certain of our reinsurance payable balances contain embedded derivatives. Such derivatives had an estimated fair value of $2.8 million and $7.3 million at December 31, 2005 and 2004, respectively. We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts). We maintain a specific block of investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income. The change in value of these trading securities should largely offset the change in the value of the embedded derivatives. Multibucket Annuity Product The Company's multibucket annuity is a fixed annuity product that credits interest based on the experience of a particular market strategy. Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company's investment portfolio. Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies. The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract. The investments backing the market strategies of these products are designated by the Company as trading securities. The change in the fair value of these securities is recognized currently in investment income which is substantially offset by the change in insurance policy benefits for these products. 19 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Fair Values of Financial Instruments We use the following methods and assumptions to determine the estimated fair values of financial instruments: Investment securities. For fixed maturity securities (including redeemable preferred stocks) and trading securities, we use quotes from independent pricing services, where available. For investment securities for which such quotes are not available, we use values obtained from broker-dealer market makers or by discounting expected future cash flows using a current market rate appropriate for the yield, credit quality, and, for fixed maturity securities, the maturity of the investment being priced. Preferred stock of affiliates. The issuers, which are subsidiaries of Conseco, may redeem the preferred stock at any time at the redemption price plus accrued and unpaid dividends. The estimated fair value of these investments approximates such redemption amounts. Cash and cash equivalents. The carrying amount of these instruments approximates their estimated fair value. Mortgage loans and policy loans. We discount future expected cash flows for loans included in our investment portfolio based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. We aggregate loans with similar characteristics in our calculations. The market value of policy loans approximates their carrying value. Other invested assets. We use quoted market prices, where available. When quotes are not available, we estimate the fair value based on discounted future expected cash flows or independent transactions which establish a value for our investment. When we are unable to estimate a fair value, we assume a market value equal to carrying value. Insurance liabilities for interest-sensitive products. We discount future expected cash flows based on interest rates currently being offered for similar contracts with similar maturities. Investment borrowings. Due to the short-term nature of these borrowings (terms generally less than 30 days), estimated fair values are assumed to approximate carrying values. 20 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- The estimated fair values of our financial instruments at December 31, 2005 and 2004, were as follows (dollars in millions):
Successor ----------------------------------------- 2005 2004 ------------------- ------------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------ ----- Financial assets: Actively managed fixed maturities....................................... $8,680.5 $8,680.5 $8,925.7 $8,925.7 Preferred stock of affiliates........................................... 58.6 58.6 59.5 59.5 Mortgage loans.......................................................... 529.8 549.8 531.3 557.2 Policy loans............................................................ 367.1 367.1 387.1 387.1 Trading securities...................................................... 420.2 420.2 587.2 587.2 Other invested assets................................................... 79.9 79.9 107.9 107.9 Cash and cash equivalents............................................... 42.8 42.8 408.2 408.2 Financial liabilities: Insurance liabilities for interest-sensitive products (a)............... 7,632.3 7,632.3 8,008.7 8,008.7 Investment borrowings................................................... 12.9 12.9 310.7 310.7 - -------------------- (a) The estimated fair value of insurance liabilities for interest-sensitive products was approximately equal to its carrying value at December 31, 2005 and 2004. This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar products and because these rates are not generally guaranteed beyond one year.
Sales Inducements Certain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract. Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time. These enhanced rates and persistency bonuses are considered sales inducements under Statement of Position 03-01 "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-01"). Such amounts are deferred and amortized in the same manner as the cost of policies produced. Sales inducements deferred totaled $44.5 million in 2005 and the amount amortized totaled $3.3 million in 2005. The unamortized balance of deferred sales inducements was $41.2 million at December 31, 2005. The balance of insurance liabilities for persistency bonus benefits was $310.2 million and $303.1 million at December 31, 2005 and 2004, respectively. 21 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Recently Issued Accounting Standards Pending Accounting Standards In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" ("SFAS 155"). SFAS 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), and SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" and resolves issues addressed in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interest in Securitized Financial Assets". SFAS 155: (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (c) establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and, (e) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. The standard also requires presentation within the financial statements that identifies those hybrid financial instruments for which the fair value election has been applied and information on the income statement impact of the changes in fair value of those instruments. SFAS 155 is effective for all financial instruments acquired or issued in a fiscal year that begins after September 15, 2006. Given its recent issuance, management is still assessing the impact SFAS 155 will have on our results of operations or financial position. In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). This statement provides guidance on accounting for deferred acquisition costs on an internal replacement which is defined broadly as a modification in product benefits, features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, feature, right, or coverage within an existing contract. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract should be accounted for as a continuation of the replaced contract. Contract modifications resulting in a replacement contract that is substantially changed from the replaced contract should be accounted for as an extinguishment of the replaced contract and any unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract should not be deferred in connection with the replacement contract. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We are currently assessing the impact of SOP 05-1, however we do not expect the pronouncement to have a material impact on our results of operations or financial position. Adopted Accounting Standards The FASB issued FASB Staff Position ("FSP") FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP FAS 106-2") in May 2004. FSP FAS 106-2 provides guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Modernization Act"). The Modernization Act provides, among other things, a federal subsidy to plan sponsors who maintain postretirement health care plans that provide prescription drug benefits and meet certain equivalency criteria. FSP FAS 106-2 superseded FSP FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003". The adoption of FSP FAS 106-2 did not have a significant impact on our consolidated financial statements. In 2003, the FASB issued Financial Accounting Standards Board Interpretation No. 46 "Consolidation of Variable Interest Entities", revised December 2003 ("FIN 46R"), which required expanded disclosures for and, in some cases, consolidation of significant investments in variable interest entities ("VIE"). A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest, or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Under FIN 46R, a company is required to consolidate a VIE if it is the primary beneficiary of the VIE. FIN 46R defines primary beneficiary as the party which will absorb a majority of the VIE's expected losses or receive a majority of the VIE's expected residual returns, or 22 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- both. The Company has investments in various types of VIEs. However, the Company is not the primary beneficiary of the VIEs and, therefore, the consolidation and disclosure requirements of FIN 46R are not applicable for these investments. The FASB issued Statement of Financial Accounting Standards No. 149 "Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April 2003. SFAS 149 amended and clarified accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." Except for certain implementation guidance included in SFAS 149 which was already effective, the new guidance was effective for: (i) contracts entered into or modified after June 30, 2003; and (ii) hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on the Company's consolidated financial statements. The FASB's Derivative Implementation Group issued DIG B36 in April 2003. DIG B36 addresses specific circumstances under which bifurcation of an instrument into a host contract and an embedded derivative is required. DIG B36 requires the bifurcation of a derivative from the receivable or payable related to a modified coinsurance agreement, where the yield on the receivable and payable is based on a return of a specified block of assets rather than the creditworthiness of the ceding company. We implemented this guidance on August 31, 2003, in conjunction with our adoption of fresh start accounting. See the note entitled "Accounting for Derivatives" for a discussion of the impact of implementing this guidance. 23 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 4. MERGER Effective October 1, 2004, BNL was merged with Washington National, with Washington National being the surviving corporation. As described in note 1, the consolidated financial statements include the assets and liabilities of BNL and the results of operations, changes in shareholder's equity and cash flows as if the companies had always been combined. The impact of the merger on certain balances reflected in the consolidated financial statements was as follows (dollars in millions):
Amount prior to Reported merger BNL amount ------ --- ------ Successor - Four months ended December 31, 2003 - ----------------------------------------------- Insurance policy income..................................................... $ 255.0 $ 9.4 $ 264.4 Net investment income....................................................... 239.0 11.1 250.1 Total revenues.............................................................. 501.2 24.2 525.4 Insurance policy benefits................................................... 320.3 12.4 332.7 Amortization................................................................ 52.6 1.3 53.9 Total benefits and expenses................................................. 465.9 17.5 483.4 Income before income taxes.................................................. 35.3 6.7 42.0 Predecessor - Eight months ended August 31, 2003 - ------------------------------------------------ Insurance policy income..................................................... 620.0 18.4 638.4 Net investment income....................................................... 481.4 24.6 506.0 Total revenues.............................................................. 1,111.2 38.3 1,149.5 Insurance policy benefits................................................... 515.8 31.7 547.5 Amortization................................................................ 151.0 2.8 153.8 Total benefits and expenses................................................. 1,058.5 1,150.2 (a) 2,208.7 Income (loss) before income taxes........................................... 52.7 (1,111.9) (1,059.2) - ------------ (a) Such amount includes $1,106.5 million of reorganization items representing the net impact from the implementation of fresh start accounting.
24 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 5. INVESTMENTS At December 31, 2005, the amortized cost and estimated fair value of actively managed fixed maturity securities and preferred stock of affiliates were as follows (dollars in millions):
Successor ------------------------------------------------ Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- Investment grade: Corporate securities................................................ $5,128.2 $111.2 $49.4 $5,190.0 United States Treasury securities and obligations of United States government corporations and agencies................ 579.2 1.3 7.0 573.5 States and political subdivisions................................... 232.6 5.2 1.8 236.0 Debt securities issued by foreign governments....................... 86.3 4.2 .1 90.4 Structured securities .............................................. 2,371.3 7.4 29.6 2,349.1 Below-investment grade (primarily corporate securities)................ 237.1 9.0 4.6 241.5 -------- ------ ----- -------- Total actively managed fixed maturities........................... $8,634.7 $138.3 $92.5 $8,680.5 ======== ====== ===== ======== Preferred stock of affiliates.......................................... $42.7 $15.9 $ - $58.6 ===== ===== ===== =====
At December 31, 2004, the amortized cost and estimated fair value of actively managed fixed maturity securities and preferred stock of affiliates were as follows (dollars in millions):
Successor ------------------------------------------------ Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- Investment grade: Corporate securities................................................ $5,297.0 $202.4 $ 8.0 $5,491.4 United States Treasury securities and obligations of United States government corporations and agencies................ 586.5 5.8 1.3 591.0 States and political subdivisions................................... 231.6 5.1 1.7 235.0 Debt securities issued by foreign governments....................... 73.8 3.1 .1 76.8 Structured securities .............................................. 2,164.7 30.7 4.1 2,191.3 Below-investment grade (primarily corporate securities)................ 317.7 23.5 1.0 340.2 -------- ------ ----- -------- Total actively managed fixed maturities........................... $8,671.3 $270.6 $16.2 $8,925.7 ======== ====== ===== ======== Preferred stock of affiliates.......................................... $42.7 $16.8 $ - $59.5 ===== ===== ===== =====
At December 31, 2005, the amortized cost of the Company's below-investment grade fixed maturity securities was $237.1 million, or 2.7 percent of the Company's fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $241.5 million, or 102 percent of the amortized cost. The value of these securities varies based on the economic terms of the securities, structural considerations and the creditworthiness of the issuer of the securities. Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk of default by the borrower is significantly greater for below-investment grade securities and in many cases, severity of loss is relatively greater as such securities are generally unsecured and often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and may be more sensitive to adverse economic conditions, such as recession or increasing interest rates. The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry. 25 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- The following table summarizes the carrying values of our actively managed fixed maturity securities by category as of December 31, 2005 (dollars in millions):
Percent of Carrying value fixed maturities -------------- ---------------- Structured securities................................................................ $2,349.2 27.1% Bank and finance..................................................................... 902.9 10.4 Manufacturing........................................................................ 892.9 10.3 Services............................................................................. 624.0 7.2 U.S. Government...................................................................... 573.5 6.6 Utilities............................................................................ 564.9 6.5 Holdings and other investment offices................................................ 500.1 5.8 Communications....................................................................... 447.1 5.1 Agriculture, forestry and mining..................................................... 321.4 3.7 Asset-backed securities.............................................................. 313.1 3.6 Transportation....................................................................... 250.6 2.9 States and political subdivisions.................................................... 247.6 2.8 Retail and wholesale................................................................. 213.5 2.5 Other................................................................................ 479.7 5.5 -------- ----- Total actively managed fixed maturities........................................... $8,680.5 100.0% ======== =====
Accumulated other comprehensive income is comprised of the net effect of unrealized appreciation on our investments. These amounts, included in shareholder's equity as of December 31, 2005 and 2004, were as follows (dollars in millions):
Successor ----------------------- 2005 2004 ---- ---- Net unrealized appreciation on investments............................................... $ 67.4 $273.1 Adjustment to value of policies inforce at the Effective Date............................ (8.7) (51.5) Adjustment to cost of policies produced.................................................. .1 - Deferred income tax liability............................................................ (20.8) (55.9) ------ ------ Accumulated other comprehensive income............................................ $ 38.0 $165.7 ====== ======
26 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 2005, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions).
Estimated Amortized fair cost value ---- ----- Due in one year or less........................................................................ $ 69.9 $ 71.2 Due after one year through five years.......................................................... 1,030.0 1,020.3 Due after five years through ten years......................................................... 2,348.1 2,359.2 Due after ten years............................................................................ 2,815.3 2,880.6 -------- -------- Subtotal.................................................................................. 6,263.3 6,331.3 Structured securities (a)...................................................................... 2,371.4 2,349.2 -------- -------- Total actively managed fixed maturities ............................................... $8,634.7 $8,680.5 ======== ======== - ------------------ (a) Includes below-investment grade structured securities with both an amortized cost and estimated fair value of $.1 million.
Net investment income consisted of the following (dollars in millions):
Successor Predecessor --------------------------------------- ------------- Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Fixed maturities....................................... $516.3 $507.0 $173.2 $402.1 Trading income related to policyholder and reinsurer accounts.................................. (.4) 4.0 6.4 - Preferred stock of affiliates.......................... 4.0 7.6 3.1 11.3 Mortgage loans......................................... 45.8 49.9 19.1 39.8 Policy loans........................................... 22.6 23.7 9.6 20.7 Change in value of options related to equity-indexed products.......................... (16.3) 17.5 40.0 25.3 Other invested assets.................................. 2.7 7.5 1.9 10.8 Cash and cash equivalents.............................. 7.6 6.5 1.9 5.4 ------ ------ ------ ------ Gross investment income............................. 582.3 623.7 255.2 515.4 Less investment expenses............................... 9.5 12.9 5.1 9.4 ------ ------ ------ ------ Net investment income............................. $572.8 $610.8 $250.1 $506.0 ====== ====== ====== ======
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $4.8 million and $6.0 million at December 31, 2005 and 2004, respectively. 27 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Net realized investment gains (losses) were included in revenue as follows (dollars in millions):
Successor Predecessor --------------------------------------- ------------ Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Fixed maturities: Gross gains............................................ $ 34.8 $ 47.8 $ 20.1 $ 84.0 Gross losses........................................... (37.7) (18.4) (11.5) (41.3) Other than temporary declines in fair value............ (1.4) (2.1) (3.2) (28.9) ------ ------ ------ ------ Net realized investment gains (losses) from fixed maturities................................. (4.3) 27.3 5.4 13.8 Other than temporary declines in fair value of equity securities and other invested assets................... (2.8) (3.8) (.2) (.6) Other..................................................... 4.5 27.5 1.4 (17.8) ------ ------ ------ ------ Net realized investment gains (losses)............... $ (2.6) $ 51.0 $ 6.6 $ (4.6) ====== ====== ====== ======
We regularly evaluate our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. When we conclude that a decline in a security's net realizable value is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value. Our assessment of whether unrealized losses are "other than temporary" requires significant judgment. Factors considered include: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) our view of the investment's rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which our investment may be affected by changes in such values. When a decline in value is determined to be other than temporary and the cost basis of the security is written down to fair value, we review the circumstances of that particular investment in relation to other investments in our portfolio. If such circumstances exist with respect to other investments, those investments are also written down to fair value. Future events may occur, or additional information may become available, which may necessitate future realized losses of securities in our portfolio. Significant losses in the carrying values of our investments could have a material adverse effect on our earnings in future periods. During 2005, we recorded writedowns of other invested assets totaling $2.8 million as a result of analysis that led us to conclude that the declines in the values of these investments were other than temporary. This total writedown was comprised of the following: (i) $1.5 million related to home office buildings which are available for sale, based on the anticipated sales prices; and (ii) $1.3 million related to two real estate investments in retail stores that are vacant and listed for sale, and have recently been re-appraised. During 2005, we recorded writedowns of actively managed fixed maturities totaling $1.4 million as a result of analysis that led us to conclude that their declines in value were other than temporary. Of this total writedown, $1.3 million related to bonds, secured by an apartment complex, which were issued as part of the USDA Section 538 program for rural housing 28 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- development. This complex has significant construction cost overruns as well as lower rents than were projected which make the viability of the USDA guarantee unclear. The remaining $.1 million of writedowns related to various other actively managed fixed maturities. The following table sets forth the amortized cost and estimated fair value of those actively managed fixed maturities with unrealized losses at December 31, 2005, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions).
Estimated Amortized fair cost value --------- --------- Due in one year or less................................................................... $ 51.4 $ 50.9 Due after one year through five years..................................................... 875.2 863.1 Due after five years through ten years.................................................... 1,160.0 1,140.2 Due after ten years....................................................................... 1,157.7 1,127.2 -------- -------- Subtotal............................................................................... 3,244.3 3,181.4 Structured securities..................................................................... 1,855.4 1,825.8 -------- -------- Total.................................................................................. $5,099.7 $5,007.2 ======== ========
At December 31, 2005, we held no investments in our fixed maturity portfolio which were rated below-investment grade and had an unrealized loss position exceeding 20 percent of the cost basis. Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities. While we have both the ability and intent to hold securities with unrealized losses until they mature or recover in value, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment. 29 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2005 (dollars in millions):
Less than 12 months 12 months or greater Total ---------------------- --------------------- ----------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of securities value losses value losses value losses ------------------------- ----- ------ ----- ------ ----- ------ United States Treasury securities and obligations of United States government corporations and agencies...... $ 474.3 $ (5.3) $ 66.0 $ (1.7) $ 540.3 $ (7.0) States and political subdivisions. 69.2 (1.1) 29.6 (1.4) 98.8 (2.5) Debt securities issued by foreign governments............ 12.8 (.1) - - 12.8 (.1) Corporate securities.............. 2,342.4 (46.1) 187.1 (7.2) 2,529.5 (53.3) Structured securities............. 1,762.0 (27.9) 63.8 (1.7) 1,825.8 (29.6) -------- ------ ------ ------ -------- ------ Total actively managed fixed maturities............... $4,660.7 $(80.5) $346.5 $(12.0) $5,007.2 $(92.5) ======== ====== ====== ====== ======== ======
The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2004 (dollars in millions):
Less than 12 months 12 months or greater Total ---------------------- ----------------------- ------------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of securities value losses value losses value losses ------------------------- ----- ------ ----- ------ ----- ------ United States Treasury securities and obligations of United States government corporations and agencies...... $ 130.3 $ (1.1) $ 2.4 $ (.2) $ 132.7 $ (1.3) States and political subdivisions. 62.2 (1.0) 14.5 (.7) 76.7 (1.7) Debt securities issued by foreign governments............ 5.5 (.1) - - 5.5 (.1) Corporate securities.............. 750.4 (8.5) 18.6 (.5) 769.0 (9.0) Structured securities............. 359.8 (3.7) 17.8 (.4) 377.6 (4.1) -------- ------ ----- ----- -------- ------ Total actively managed fixed maturities............... $1,308.2 $(14.4) $53.3 $(1.8) $1,361.5 $(16.2) ======== ====== ===== ===== ======== ======
Based on management's current assessment of investments with unrealized losses at December 31, 2005, the Company believes the issuers of the securities will continue to meet their obligations. The Company has no current plans to sell these 30 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- securities and has the ability to hold them to maturity. If the Company concludes in future periods that the unrealized loss is other than temporary, a charge to earnings would be recognized. Mortgage Loans At December 31, 2005, the mortgage loan balance was primarily comprised of commercial loans. Approximately 12 percent and 8 percent of the mortgage loan balance were on properties located in Ohio and Florida, respectively. No other state comprised greater than 5 percent of the mortgage loan balance. Our allowance for loss on mortgage loans was $1.6 million at both December 31, 2005 and 2004. Noncurrent mortgage loans were insignificant at December 31, 2005. Other Investment Disclosures Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $74.3 million and $80.3 million at December 31, 2005 and 2004, respectively. The Company had two investments in excess of 10 percent of shareholder's equity at both December 31, 2005 and 2004 (other than investments issued or guaranteed by the United States government or a United States government agency) which are summarized below (dollars in millions):
Successor ---------------------------------------------------------- 2005 2004 -------------------------- ---------------------------- Amortized Estimated Amortized Estimated Issuer cost fair value cost fair value ------ ---- ---------- ---- ---------- Federal Home Loan Mortgage Corporation....................... $1,222.4 $1,210.8 $842.6 $849.7 Federal National Mortgage Association....................... 549.6 545.4 305.9 309.0
31 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 6. LIABILITIES FOR INSURANCE PRODUCTS These liabilities consisted of the following (dollars in millions):
Successor Interest ----------------------------- Withdrawal Mortality rate December 31, December 31, assumption assumption assumption 2005 2004 ---------- ---------- ---------- ---- ---- Future policy benefits: Interest-sensitive products: Investment contracts............................ N/A N/A (c) $ 4,278.9 $ 4,612.4 Universal life contracts........................ N/A N/A N/A 3,353.4 3,396.3 --------- --------- Total interest-sensitive products............. 7,632.3 8,008.7 --------- --------- Traditional products: Traditional life insurance contracts............ Company experience (a) 5% 1,057.8 1,095.9 Limited-payment annuities....................... Company experience, if applicable (b) 4% 597.6 661.6 Individual and group accident and health........ Company Company experience experience 5% 522.7 557.8 --------- --------- Total traditional products.................... 2,178.1 2,315.3 --------- --------- Claims payable and other policyholder funds ........ N/A N/A N/A 380.8 405.2 --------- --------- Total......................................... $10,191.2 $10,729.2 ========= ========= - ------------- (a) Principally modifications of the 1965 - 70 Basic Tables. (b) Principally, the 1984 United States Population Table and the NAIC 1983 Individual Annuity Mortality Table. (c) In 2005 and 2004, all of this liability represented account balances where future benefits are not guaranteed.
The Company establishes reserves for insurance policy benefits based on assumptions as to investment yields, mortality, morbidity, withdrawals, lapses and maintenance expenses. These reserves include amounts for estimated future payment of claims based on actuarial assumptions. The balance is based on the Company's best estimate of the future policyholder benefits to be incurred on this business, given recent and expected future changes in experience. 32 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- In accordance with SOP 90-7, the Successor valued insurance liabilities and an asset for the value of policies inforce at the Effective Date using current assumptions. The adjustments to the Predecessor's liabilities for insurance products as of August 31, 2003 are summarized below (dollars in millions):
Predecessor Fresh start Successor balance sheet adjustments balance sheet ------------- ----------- ------------- Liabilities for insurance products: Traditional and limited payment products: Traditional life insurance products .............................. $ 903.2 $141.1 $ 1,044.3 Limited pay annuities............................................. 563.2 108.5 671.7 Individual and group accident and health ......................... 423.4 109.9 533.3 --------- ------ --------- Total liabilities for traditional and limited payment products. 1,889.8 359.5 2,249.3 --------- ------ --------- Interest-sensitive products: Investment contracts ............................................. 4,992.0 158.5 5,150.5 Universal life products .......................................... 3,662.4 (10.7) 3,651.7 --------- ------ --------- Total liabilities for interest-sensitive products.............. 8,654.4 147.8 8,802.2 --------- ------ --------- Other liabilities for insurance products: Separate accounts................................................. 37.8 - 37.8 Claims payable and other policyholder funds ...................... 425.9 .1 426.0 --------- ------ --------- Total other liabilities for insurance products................. 463.7 .1 463.8 --------- ------ --------- Total liabilities for insurance products................................. $11,007.9 $507.4 $11,515.3 ========= ====== =========
The following provides explanations for the fresh-start adjustments to insurance liabilities related to our insurance inforce at the Effective Date. Traditional insurance and limited pay products In accordance with Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" and Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises for certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial assumptions determined when the traditional long-duration and limited payment insurance contracts were issued in determining liability calculations as of the fresh start date, provided the resulting liabilities were adequate to provide for future benefits and expenses under the related contracts. This accounting principle is referred to as the "lock in" principle and is only applicable to traditional insurance and limited pay products. The use of assumptions that are locked in at the time of issue means that, absent loss recognition, the same assumptions are used in accounting for a particular block of business unless the block is subject to purchase or fresh start accounting. At the Effective Date, the Successor established insurance liabilities at the present value of future benefits and expenses less future premiums associated with the policies, by using current best-estimate assumptions with provisions for adverse deviation. Such assumptions included estimates as to investment yields, mortality, morbidity, withdrawals, lapses and maintenance expenses. The current best-estimate assumptions for these blocks of business differed from the original actuarial assumptions determined when the business was acquired or issued as further described in the following paragraphs. Due to the current interest rate environment and the requirement to mark the value of the investment portfolio to market, we changed our assumptions related to future investment earnings. The weighted average expected yield on our 33 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- investment portfolio decreased to approximately 5.6 percent at the Effective Date from 6.7 percent at December 31, 2002. Approximately $.2 billion of the fresh-start increase to insurance liabilities was the result of changes in future expected investment earnings. Interest-sensitive products subject to requirements of SFAS 97 The insurance liability for asset accumulation products (such as deferred annuities and universal life products) is generally equal to current policyholder account balances. These balances generally do not change as a result of the adoption of fresh start accounting. The fresh-start adjustment to insurance liabilities for interest-sensitive products primarily resulted from: (i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain Predecessor insurance liabilities that were different from the present value of estimated future benefits as of August 31, 2003. The adoption of SOP 03-01 as of the Effective Date required a change in methodology regarding persistency bonuses provided to policyholders who continue to keep their policies inforce for a stated period of time. The Predecessor recognized the cost of this benefit over the period prior to the time the benefit would be credited in proportion to estimated gross profits and assumed a certain number of policies would terminate before the benefit was credited. Under SOP 03-01, the cost for such benefits is recognized ratably over the period prior to the time the benefit is credited without assuming policy terminations. Insurance liabilities increased by approximately $.1 billion as a result of the adoption of SOP 03-01. In addition, the insurance liabilities for certain Predecessor insurance liabilities were different than the present value of estimated future benefits as of the Effective Date. The Predecessor had previously established an insurance liability related to certain business to recognize the future loss expected to be recognized for the former practice of reducing the cost of insurance charges to amounts below the level permitted under the provisions of the policy. The Predecessor amortized this liability into income in proportion to estimated gross profits on the business, consistent with SFAS 97 requirements for unearned revenues. The Predecessor had previously decided to discontinue the practice of providing this nonguaranteed benefit. Accordingly, the remaining insurance liability established for this benefit was no longer required at August 31, 2003, resulting in a $.1 billion reduction to reserves in conjunction with our adoption of fresh-start accounting. The liabilities established for our equity-indexed annuity products (including the value of options attributable to policyholders for the estimated life of the annuity contract and accounted for as embedded derivatives) were established pursuant to different accounting rules than other interest-sensitive products. At the Effective Date, the present value of estimated future benefits for our equity-indexed products exceeded the value of the Predecessor's liabilities by $.1 billion, resulting in a fresh-start adjustment. 34 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 7. INCOME TAXES The components of the Company's income tax assets and liabilities were as follows (dollars in millions):
Successor ------------------------------ December 31, December 31, 2005 2004 ---- ---- Deferred tax assets: Net operating loss carryforwards......................................................... $ 58.0 $ 47.1 Capital loss carryforwards............................................................... 332.8 322.5 Insurance liabilities.................................................................... 510.4 557.3 ------- ------- Gross deferred tax assets.......................................................... 901.2 926.9 ------- ------- Deferred tax liabilities: Actively managed fixed maturities........................................................ (38.7) (32.4) Value of policies inforce at the Effective Date and cost of policies produced............ (232.1) (242.0) Unrealized appreciation of investments................................................... (20.8) (55.9) Other.................................................................................... (115.0) (102.5) ------- ------- Gross deferred tax liabilities...................................................... (406.6) (432.8) ------- ------- Net deferred tax assets before valuation allowance.................................. 494.6 494.1 Valuation allowance...................................................................... (332.8) (369.6) ------- ------- Net deferred tax assets............................................................. 161.8 124.5 Current income taxes prepaid................................................................. 3.1 27.6 ------- ------- Income tax assets, net.............................................................. $ 164.9 $ 152.1 ======= =======
The components of income tax expense (benefit) were as follows (dollars in millions):
Successor Predecessor --------------------------------------- ------------ Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Current tax expense (benefit)............................. $ 5.7 $(31.5) $(69.0) $(28.1) Deferred tax provision.................................... 29.9 73.4 84.0 - ----- ------ ------ ------ Income tax expense (benefit) on period income...... $35.6 $ 41.9 $ 15.0 $(28.1) ===== ====== ====== ======
35 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- A reconciliation of the U.S. statutory corporate tax rate to the effective rate reflected in the consolidated statement of operations is as follows:
Successor Predecessor ---------------------------------------- ------------ Years Four months Eight months ended ended ended December 31, December 31, August 31, -------------------- ------------ ------------ 2005 2004 2003 2003 ---- ---- ---- ---- U.S. statutory corporate rate......................... 35.0% 35.0% 35.0% (35.0)% State taxes........................................... .8 .4 .7 .1 Nontaxable investment income.......................... (1.2) (1.6) (2.5) (.4) Income tax credits.................................... - - (.5) (.2) Valuation allowance................................... - - - (10.8) Reorganization items.................................. - - - 43.8 Other nondeductible expenses.......................... - (6.1) 2.9 - Provision for tax issues, tax credits and other....... (1.6) (.1) .1 (.2) ---- ---- ---- ----- Effective tax rate............................... 33.0% 27.6% 35.7% (2.7)% ==== ==== ==== =====
In 2005, the Internal Revenue Service ("IRS") completed its examination of the Company for the tax year ending December 31, 2002, and there were no significant adjustments. Conseco and its affiliates are currently under examination by the IRS for the tax year ending December 31, 2003. The outcome of this examination is not expected to have a material adverse affect on our operating results. At December 31, 2005, the Company had NOLs of $165.6 million available for use on future tax returns. These carryforwards will expire as follows: $13.1 million in 2012; $49.3 million in 2016; $33.2 million in 2017; $49.4 million in 2018; and $20.6 million in 2019. All but $20.7 million of these carryforwards are subject to the Section 382 limitation discussed below. In addition, at December 31, 2005, the Company had capital loss carryforwards of $950.9 million available for use on future tax returns. These carryforwards will expire as follows: $5.5 million in 2006; $354.6 million in 2007; $526.5 million in 2008; and $64.3 million in 2009. All but $64.3 million of these carryforwards are subject to the Section 382 limitation discussed below. The timing and manner in which we will be able to utilize the NOLs and capital loss carryforwards in any year or in total may be limited by various provisions of the Internal Revenue Code (the "Code") (and interpretations thereof) and our ability to generate sufficient future taxable income in the relevant carryforward period. Section 382 of the Code imposes limitations on a corporation's ability to use its NOLs when the company undergoes an ownership change. Because the Company's ultimate parent company underwent an ownership change pursuant to its reorganization, we have determined that this limitation applies to the Company. Any losses that are subject to the Section 382 limitation will only be utilized by the Company on a consolidated basis with the Company's ultimate parent up to approximately $140 million per year with any unused amounts carried forward to the following year. Prior to January 1, 1984, the Company was entitled to exclude certain amounts from taxable income and accumulate such amounts in a "Policyholders Surplus Account". Pursuant to the American Jobs Creation Act of 2004 (the "2004 Act"), the Company may reduce the Policyholders Surplus Account in 2006 without incurring any tax liability. The aggregate balance in this account at December 31, 2005 was $9.2 million, which prior to the 2004 Act would have resulted in federal income taxes payable of $3.2 million if such amounts had been distributed or deemed distributed from the Policyholders Surplus Account. No provision for taxes has ever been made for this item since the Company had no intention of distributing such amounts. The Company expects to utilize this provision, thereby eliminating or substantially reducing this potential tax liability. The reduction in our deferred income tax valuation allowance was accounted for pursuant to SOP 90-7, as follows: (i) 36 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- first, to eliminate goodwill; (ii) second, to eliminate other intangible assets; and (iii) last, as an addition to paid-in capital. Since all goodwill and applicable intangible assets were eliminated in 2004, the reduction of any remaining portion of our deferred income tax valuation allowance will be accounted for as an addition to paid-in capital pursuant to SOP 90-7. Changes in our valuation allowance are summarized as follows (dollars in millions): Balance at August 31, 2003...................................... $ 705.0 Reduction of tax valuation allowance established at the Effective Date(a).................................... (128.7) ------- Balance at December 31, 2003.................................... 576.3 Release of valuation allowance(b)............................. (206.7) ------- Balance at December 31, 2004.................................... 369.6 Deferred taxes not realizable................................. (3.5) Release of valuation allowance(c)............................. (33.3) ------- Balance at December 31, 2005.................................... $ 332.8 ======= ------------- (a) There was a corresponding decrease to goodwill. (b) There was a corresponding increase (decrease) in the following accounts: (i) goodwill - $(106.8) million; (ii) other intangible assets - $(9.6) million; and (iii) additional paid-in capital - $90.3 million. (c) There was a corresponding increase to additional paid-in capital.
In reducing our tax valuation allowance, we evaluated the likelihood that we will have sufficient taxable income to offset the available deferred tax assets. This assessment required significant judgment. Based upon our current projections of future income that we completed at December 31, 2005, we believe that we will more likely than not recover $161.8 million of our deferred tax assets through reductions of our tax liabilities in future periods. However, recovery is dependent on achieving such projections and failure to do so would result in an increase in the valuation allowance in a future period. Any future increase in the valuation allowance would result in additional income tax expense and reduce shareholder's equity, and such an increase could have a significant impact upon our earnings in the future. 8. COMMITMENTS AND CONTINGENCIES Litigation Legal Proceedings The Company and its subsidiaries are involved in various legal actions in the normal course of business, in which claims for compensatory and punitive damages are asserted, some for substantial amounts. Some of the pending matters have been filed as purported class actions and some actions have been filed in certain jurisdictions that permit punitive damage awards that are disproportionate to the actual damages incurred. Although there can be no assurances, at the present time the Company does not anticipate that the ultimate liability from either pending or threatened legal actions, after consideration of existing loss provisions, will have a material adverse effect on the financial condition, operating results or cash flows of the Company. The amounts sought in certain of these actions are often large or indeterminate and the ultimate outcome of certain actions is difficult to predict. In the event of an adverse outcome in one or more of these matters, the ultimate liability may be in excess of the liabilities we have established and could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, the resolution of pending or future litigation may involve modifications to the terms of outstanding insurance policies, which could adversely affect the future profitability of the policies at issue. In the cases described below, we have disclosed any specific dollar amounts sought in the complaints. In our 37 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- experience, monetary demands in complaints bear little relation to the ultimate loss, if any, to the Company. However, for the reasons stated above, it is not possible to make meaningful estimates of the amount or range of loss that could result from some of these matters at this time. The Company reviews these matters on an ongoing basis and follows the provisions of Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies", when making accrual and disclosure decisions. When assessing reasonably possible and probable outcomes, the Company bases its decisions on its assessment of the ultimate outcome following all appeals. Cost of Insurance Litigation Certain affiliates of the Company, including principally Conseco Life, have been named in numerous purported class action and individual lawsuits alleging, among other things, breach of contract, fraud and misrepresentation with regard to a change made in 2003 and 2004 in the way cost of insurance charges are calculated for life insurance policies sold primarily under the names "Lifestyle" and "Lifetime". Approximately 86,500 of these policies were subject to the change, which resulted in increased monthly charges to the policyholders' accounts. Many of the purported class action lawsuits were filed in Federal courts across the United States. In June 2004, the Judicial Panel on Multidistrict Litigation consolidated these lawsuits into the action now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California). In September 2004, plaintiffs in the multi-district action filed an amended consolidated complaint and, at that time, added Conseco, Inc. as a defendant. The amended complaint alleges, among other things, that the change enabled Conseco, Inc. to add $360 million to its balance sheet. The amended complaint seeks unspecified compensatory, punitive and exemplary damages as well as an injunction that would require the Company to reinstate the prior method of calculating cost of insurance charges and refund any increased charges that resulted from the change. On April 26, 2005, the Judge in the multi-district action certified a nationwide class on the claims for breach of contract and injunctive relief. On April 27, 2005, the Judge issued an order certifying a statewide California class for injunctive and restitutionary relief pursuant to California Business and Professions Code Section 17200 and breach of the duty of good faith and fair dealing, but denied certification on the claims for fraud and intentional misrepresentation and fraudulent concealment. Trial is currently set to begin on or about October 24, 2006. In an attempt to avoid the risks and costs associated with protracted litigation, we have been involved in settlement discussions regarding this matter. During 2005, we increased our litigation accrual related to this litigation. Other cases now pending include purported nationwide class actions in Indiana and California state courts. Those cases filed in Indiana state courts have been consolidated into the case now referred to as Arlene P. Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Four putative nationwide and/or statewide class-action lawsuits filed in California state courts have been consolidated and are being coordinated in the Superior Court of San Francisco County under the new caption Cost of Insurance Cases, Judicial Council Coordination Proceeding No. 4384 (Judicial Council of California). On January 25, 2005 an Amended Complaint making similar allegations was filed in the case captioned William Schwartz v. Jeffrey Landerman, Diann P. Urbanek, Metro Insurance, Inc., Samuels Jacky Insurance Agency, Conseco Life Insurance Company, Successor to Philadelphia Life Insurance Company, Case No. GD 00-011432 (Court of Common Pleas, Allegheny County, Pennsylvania). Additionally, Mr. Schwartz filed a purported nationwide class action captioned William Schwartz and Rebecca R. Frankel, Trustee of the Robert M. Frankel Irrevocable Insurance Trust v. Conseco Life Ins. Co. et al., Case No. GD 05-3742 (Court of Common Pleas, Allegheny County, Pennsylvania). On December 22, 2005 a lawsuit was filed in Pennsylvania captioned Lisa M. Jordan v. Allen R. Shank and Conseco Life Insurance Company, Case No. 05-10204 (Court of Common Pleas, Chester County, Pennsylvania). We believe these lawsuits are without merit and intend to defend them vigorously. However, the ultimate outcome of these lawsuits cannot be predicted with certainty and an adverse outcome could exceed the amount we have accrued and could have a material impact on the Company's consolidated financial condition, cash flows or results of operations. Other Litigation On December 1, 2000, the Company's former subsidiary, Manhattan National Life Insurance Company, was named in a purported nationwide class action seeking unspecified damages in the First Judicial District Court of Santa Fe, New Mexico, Robert Atencio and Theresa Atencio, for themselves and all other similarly situated v. Manhattan National Life Insurance 38 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Company, an Ohio corporation, Cause No. D-0101-CV-2000-2817, alleging among other things fraud by non-disclosure of additional charges for those policyholders paying via premium modes other than annual. We retained liability for this litigation in connection with the sale of Manhattan National Life Insurance Company in June 2002. Shortly after Manhattan National Life Insurance Company filed a motion to dismiss this case, Plaintiffs voluntarily dismissed this action on April 4, 2006. In October 1997, an action was filed against Conseco Variable Insurance Company ("CVIC"), a former subsidiary of the Company, and general agent Glenn H. Guffey by nine South Carolina agents, who alleged that they had suffered losses as a result of defendants' breach of contract, fraud and misleading conduct relating to the sale of Flex II annuities. In the action, Thomas Allen et al v. Great American Reserve Insurance Company, Glenn H. Guffey and American Home Assurance Company, Case Number 29C01-9709-CP751 in the Circuit Court of Hamilton County, Indiana, plaintiffs claim that Mr. Guffey told them that the annuities would have no initial administrative fees charged to the owner of the annuity (when in fact they did) and that as a result, they had been selling the annuities on that basis. Plaintiffs demanded unspecified compensatory and punitive damages, and allege that they have lost commissions and renewals and that their business reputations have been damaged as a result of Mr. Guffey's misrepresentations. They further contend that CVIC should be held liable as it negligently supervised Mr. Guffey and knew about his fraudulent conduct. Defendants were granted a Summary Judgment on February 9, 2000, but plaintiffs appealed the judgment, and the Indiana Supreme Court overturned it on April 2, 2002. Mr. Guffey has settled with plaintiffs, and the case against CVIC is now set for a jury trial commencing July 31, 2006. We retained liability for CVIC's involvement in this litigation in connection with the sale of CVIC. We believe this action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty. On December 19, 2001, three of the Company's subsidiaries were named in a purported nationwide class action seeking unspecified damages in the District Court of Adams County, Colorado, Jose Medina and others similarly situated v. Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers National Life Insurance Company and Bankers Life and Casualty Company, Cause No. 01-CV-2465, alleging among other things breach of contract regarding alleged non-disclosure of additional charges for those policyholders paying via premium modes other than annual. On November 10, 2003, the court denied the plaintiff's motion for class certification. On January 26, 2004, the plaintiff appealed the trial court's ruling denying class certification, but the Colorado Court of Appeals upheld the trial court's ruling on August 25, 2005. Plaintiffs' counsel indicated that they were going to re-file the case with a smaller proposed plaintiff class. We settled the case to avoid further litigation. On July 9, 1999, a complaint was filed in the Supreme Court of the State of New York, County of New York, PRG Planning & Development, LLC v. LateNite Magic, Inc., Daurio & Russo & Sons Construction Co., Inc., Specialized Audio Visual, Inc., Farmore Realty, Inc. f/k/a Sweetheart Theatres, Inc., The City of New York and the State of New York Cause No: 114077/99. The complaint seeks damages in the amount of $3.9 million with interest thereon from January 20, 1998. This is a lien foreclosure suit that is the result of an April 1996 lease agreement entered into by LateNite Magic and Farmore Realty, Inc. to develop a theme restaurant based on the magic of David Copperfield. CVIC and CIC purchased preferred stock of LateNite and acquired the right to an assignment of the April 1996 lease. An amended complaint was filed on December 2, 1999 naming CVIC and CIC as co-defendants. The trial in this case commenced on March 10, 2005 and concluded on May 20, 2005. The post trial briefs have been submitted and a decision could come at any time. We believe that we have established adequate reserves in the event we are found liable under this lawsuit. The ultimate outcome of the lawsuit cannot be predicted with certainty. On October 8, 2003, a complaint was filed in the United States District Court for South Carolina, Greenville Division, Consolidated Insured Benefits, Inc. and Ronald F. English v. Conseco Medical Insurance Company, Cause No. 6:03-3211-20. Plaintiffs are a former Conseco Medical Insurance Company ("CMIC") field marketing organization and its president and chief executive officer, and they allege in the complaint that they were damaged by CMIC's exit from the individual medical insurance market claiming damages in an unnamed amount for fraud, negligent misrepresentation and breach of fiduciary duty. CMIC has filed a motion for summary judgment, and the court has enlarged the time for discovery to July 2006. In addition, CMIC filed a motion requesting that the case be moved to the U.S. District Court in Indianapolis. We anticipate a ruling on this motion by the third quarter of 2006. The case is expected to be set for trial in 2007. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty. 39 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- On November 17, 2005, a complaint was filed in the United States District Court for the Northern District of California, Robert H. Hansen, an individual, and on behalf of all others similarly situated v. Conseco Insurance Company, an Illinois corporation f/k/a Conseco Annuity Assurance Company, Cause No. C0504726. Plaintiff in this putative class action purchased an annuity in 2000 and is claiming relief on behalf of the proposed national class for alleged violations of the Racketeer Influenced and Corrupt Organizations Act (RICO); elder abuse; unlawful, deceptive and unfair business practices; unlawful, deceptive and misleading advertising; breach of fiduciary duty; aiding and abetting of breach of fiduciary duty; and unjust enrichment and imposition of constructive trust. On January 27, 2006, a similar complaint was filed in the same court entitled Friou P. Jones, on Behalf of Himself and All Others Similarly Situated v. Conseco Insurance Company, an Illinois company f/k/a Conseco Annuity Assurance Company, Cause No. C06-00537. Mr. Jones had purchased an annuity in 2003. Each case alleged that the annuity sold was inappropriate and that the annuity products in question are inherently unsuitable for seniors age 65 and older. On March 3, 2006 a first amended complaint was filed in the Hansen case adding Friou P. Jones as a named Plaintiff and adding causes of action for fraudulent concealment and breach of the duty of good faith and fair dealing. This in effect has consolidated the two cases, and the original Jones case will be dismissed. The court has not yet made a determination whether the case should go forward as a class action, and we intend to oppose any form of class action treatment of these claims. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty. On November 6, 2003, a Complaint was filed in State Court in Fulton County, Georgia, Reginald Martin Agency, Inc.; Comprehensive Insurance Marketing, Inc.; Design Benefits Inc.; Jim Jasnoski d/b/a Design Benefits, Inc.; Kenny Froug d/b/a Atlanta Brokerage Office; Brokerage One Agency, Inc.; Tri-State Brokerage, Inc.; Don Sepulveda d/b/a Sepulveda Insurance Group; Dean Vandersnick d/b/a Professional Insurance Brokerage and Whitewater Brokerage, Inc. v. Conseco Medical Insurance Company, Conseco Marketing LLC, Timothy F. O'Keefe and Edward M. Berube, Cause No. 03VC0587 B4Y. Plaintiffs are former CMIC Field Marketing Organizations that allege in the complaint that they were damaged by CMIC's exit from the individual medical insurance market claiming damages in an unnamed amount for breach of contract, fraud, negligent misrepresentation, breach of partnership agreements and fiduciary duty, breach of implied covenant of good faith and fair dealing, tortuous interference with business and contractual relationships, damage to goodwill and business reputation and bad faith. At CMIC's request, the case was removed to federal court and transferred to the United States District Court for the Southern District of Indiana, Indianapolis Division (Cause No. 1:04-CV-1587-TAB/RLY). CMIC filed a motion to dismiss, and all of the causes of action have been dismissed except the fraud count and the action for breach of fiduciary duty. The case is set to go to trial on March 5, 2007. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty. On January 31, 2003, a complaint was filed in the Circuit Court of Rock County, Wisconsin, School District of Beloit v. Conseco Life Insurance Company f/k/a Philadelphia Life Insurance Company, Daniel Boutelle, Combined Insurance Group, Inc., H.E.P. Administrators, Inc., and Beloit Memorial Hospital, Inc., Case No. 03-CV-134. A first amended complaint was filed on or about October 1, 2003, adding Sympson & Associates, Inc. and Reinsurance Consultants, LTD. The lawsuit involves two stop loss policies under which coverage was provided by Conseco Life to the School District of Beloit with respect to its employees' group health plan. The matter has been settled. The case is to be dismissed. Conseco Annuity Assurance Company f/k/a Beneficial Standard Life has filed suit against J.C. Penney a/k/a Stonebridge in a case captioned, Beneficial Standard Life Insurance Company v. J.C. Penney Life Insurance Company, and J.C. Penney Company, Inc., United States District Court for the Central District of California, Case No. CV-98-02792-SVW. This litigation arises from the 1967 sale of Beneficial Fire & Casualty ("BF&C") by Beneficial Standard Life Insurance Company ("Beneficial") to J.C. Penney Company, Inc. ("Penney"). The subject of the case is whether Beneficial must indemnify Penney for losses and expenses incurred as a result of claims arising under pre-sale BF&C insurance policies. Beneficial filed suit in April 1998 seeking a judicial declaration that: (1) it was not generally obligated to indemnify Penney under the terms of the agreement governing the 1967 sale; and (2) that with respect to certain environmental claims asserted by the Port of Oakland, any indemnification obligation was excused by Penney's conduct in handling the claims. Penney counterclaimed for breach of contract and declaratory relief. The counterclaim does not specify the damages sought by Penney on the breach of contract claim. After a bench trial in 2002, certain rulings of the trial court were appealed to the United States Court of Appeals for the Ninth Circuit. In June 2005, the Ninth Circuit issued an opinion holding that the terms of the 1967 sale generally require Beneficial to indemnify Penney for net liabilities arising from pre-sale policies, but only after Penney pursues and exhausts available reinsurance. The Ninth Circuit remanded the case to the trial court for further 40 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- proceedings to determine if this obligation has been excused with respect to specific claims at issue in the case. We are now preparing an amended complaint to be filed against Stonebridge. The ultimate outcome of the action cannot be predicted with certainty. In addition, the Company and its subsidiaries are involved on an ongoing basis in other arbitrations and lawsuits, including purported class actions, related to our operations. The ultimate outcome of all of these other legal matters pending against the Company or its subsidiaries cannot be predicted, and, although such lawsuits are not expected individually to have a material adverse effect on the Company, such lawsuits could have, in the aggregate, a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations. Regulatory Examinations and Fines Insurance companies face significant risks related to regulatory investigations and actions. Regulatory investigations generally result from matters related to sales or underwriting practices, payment of contingent or other sales commissions, claim payments and procedures, product design, product disclosure, additional premium charges for premiums paid on a periodic basis, denial or delay of benefits, charging excessive or impermissible fees on products, changing the way cost of insurance charges are calculated for certain life insurance products or recommending unsuitable products to customers. We are, in the ordinary course of our business, involved in various examinations and inquiries subjecting us to information requests from state and other authorities. The ultimate outcome of these examinations cannot be predicted with certainty. In the event of an unfavorable outcome in one or more of these matters, the ultimate liability may be in excess of liabilities we have established and we could suffer significant reputational harm as a result of these matters, which could also have a material adverse effect on our business, financial condition, results of operations or cash flows. During the first quarter of 2006, certain of our insurance subsidiaries (Conseco Insurance Company, Conseco Life Insurance Company and Washington National Insurance Company) agreed to settle matters resulting from a market conduct examination by the Minnesota Commerce Department. A fine of $2.1 million was agreed to and has been accrued in our consolidated financial statements as of December 31, 2005. Such fine was paid in April 2006. The terms of the settlement could result in additional benefits or options being offered to certain policyholders. Minnesota owners of equity-indexed annuities issued by Conseco Insurance Company purchased on or after January 1, 1998, will receive the opportunity to initiate a Conseco internal review and arbitration process to determine whether they adequately understood the renewal participation rate feature of their policy at the time the policy was originally sold. Policyholders who can prove they did not understand renewal participation rates at the time the policy was originally sold based on representations or omissions made by the Company or its agents may be provided relief in the form of adjusted participation rates. Within 60 days, we will send a separate notice to affected policyholders to advise them of their options. There are approximately 2,000 policyholders in this group. To date, policyholders have not asserted claims with significant exposure to the Company related to the potential issues addressed in the settlement. However, management considers it probable that additional claims will be asserted and there is a reasonable possibility that the outcome will be unfavorable. Although the outcome of the procedures required by the settlement cannot be predicted with certainty, management currently believes the cost of resolving these matters will not result in a loss which exceeds the amount accrued by more than $5 million. Guaranty Fund Assessments The balance sheet at December 31, 2005, included: (i) accruals of $9.8 million, representing our estimate of all known assessments that will be levied against the Company by various state guaranty associations based on premiums written through December 31, 2005; and (ii) receivables of $5.4 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2004, such guaranty fund assessment accruals were $10.1 million and such receivables were $6.0 million. These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies. We recognized expense (benefit) for such assessments of $.8 million in 2005; $(3.8) million in 2004; $.4 million in the four 41 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- months ended December 31, 2003; and $2.6 million in the eight months ended August 31, 2003. Leases The Company rents office space, equipment and computer software under noncancellable operating leases. The Company subleases an office building to an unaffiliated company. The building is leased from a joint venture partnership in which the Company has a one-third interest. Total rent expense was $7.3 million in 2005; $8.7 million in 2004; $3.1 million in the four months ended December 31, 2003; and $6.7 million in the eight months ended August 31, 2003. Future required minimum payments as of December 31, 2005, were as follows (dollars in millions): 2006........................................................ $ 3.7 2007........................................................ 3.7 2008........................................................ 3.8 2009........................................................ 3.9 2010........................................................ 4.0 Thereafter.................................................. 9.5 ----- Total....................... $28.6 =====
9. OTHER DISCLOSURES Postretirement Plan For our postretirement plan, in periods subsequent to the Effective Date, it is our policy to immediately recognize changes in the actuarial benefit obligation resulting from either actual experience being different than expected or from changes in actuarial assumptions. This differs from the method used by our Predecessor, whereby, such gains (losses) were recognized over the expected service lives of the participants. Effective December 31, 2005, the Company terminated its postretirement benefit plan. Prior to the termination of such plan, the Company provided certain health care and life insurance benefits for certain eligible retired employees under an unfunded plan. An actuarial measurement date of September 30 was used for this plan. In 2005, we recognized a gain of $8.8 million on the termination of this plan. The costs incurred on this plan during 2004 were reduced by $7.9 million related to the recognition of changes in the actuarial benefit obligation resulting either from actual experience being different than expected or from changes in actuarial assumptions. The remaining liability at December 31, 2005, relates to benefits to be paid in 2006. Amounts related to the postretirement benefit plan were as follows (dollars in millions):
Successor ---------------------------- December 31, December 31, 2005 2004 ---- ---- Benefit obligation, beginning of year......................................... $ 9.4 $18.1 Interest cost............................................................. .5 1.0 Plan participants' contributions.......................................... .6 - Actuarial gain............................................................ - (7.9) Gain on plan termination.................................................. (8.8) - Benefits paid............................................................. (1.4) (1.8) ----- ----- Benefit obligation, end of year............................................... $ .3 $ 9.4 ===== ===== Funded status - accrued benefit cost.......................................... $ .3 $ 9.4 ===== =====
42 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- We used the following weighted average assumptions to calculate:
2004 ---- Benefit obligations: Discount rate......................................................... 5.75% Net periodic cost: Discount rate......................................................... 6.3%
The following assumed health care cost trend rates were used to determine our postretirement benefit obligation:
2004 ---- Initial healthcare cost trend rate........................................ 10.0% Ultimate health care cost trend rate...................................... 6.0% Year the rate reaches the ultimate trend rate............................. 2015
Components of the cost we recognized related to our postretirement plan were as follows (dollars in millions):
Successor Predecessor --------------------------------------- ----------- Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Cost of postretirement benefits: Interest cost....................................... $ .5 $ 1.0 $ .4 $ .7 Curtailment gain.................................... (8.8) - - - Recognized net actuarial gain....................... - (7.9) (.3) (.5) ----- ----- ---- ---- Net periodic cost (benefit)...................... $(8.3) $(6.9) $ .1 $ .2 ===== ===== ==== ====
Related Party Transactions The Company operates without direct employees through management and service agreements with subsidiaries of Conseco. Fees for such services (including data processing, executive management and investment management services) are based on Conseco's direct and directly allocable costs plus a 10 percent margin. Total fees incurred by the Company under such agreements were $150.4 million in 2005; $178.4 million in 2004; $61.7 million in the four months ended December 31, 2003; and $121.7 million in the eight months ended August 31, 2003. Under a Stock Exchange Agreement dated September 11, 2003, the Company exchanged its preferred stock of CIHC for an equal value, including accrued paid-in-kind dividends of preferred stock of CDOC, Inc. ("CDOC"), the Company's indirect parent and a wholly owned subsidiary of Conseco. In June 2004, CDOC executed a partial redemption of the preferred stock at par value plus accrued dividends resulting in a gain of $25.9 million for the Company. In November 2004, the Company paid a dividend of $17.1 million to its parent in the form of certain shares of CDOC preferred stock. At December 31, 2005 and 2004, the Company held preferred stock of CDOC of $57.0 million and $57.8 million, respectively. In addition, at December 31, 2005 and 2004, the Company held preferred stock of another affiliate of $1.6 million and $1.7 million, respectively. During the eight months ended August 31, 2003, the Company received capital contributions from its parent totaling $28.6 million, which was paid in cash. 43 At December 31, 2003, the Company had a $50.0 million surplus debenture payable to its parent. The note bore interest at 10 percent and was payable quarterly. Effective March 31, 2004, the surplus debenture was contributed by the Company's parent to the Company and was cancelled. Interest expense on the surplus debenture totaled $1.7 million in the four months ended December 31, 2003; and $3.4 million in the eight months ended August 31, 2003. During 2004, the Company paid cash dividends to its parent totaling $90.0 million. During the four months ended December 31, 2003, the Company paid dividends to its parent totaling $70.0 million. Such dividends consisted of: (i) cash dividends of $52.3 million; and (ii) the transfer of actively managed fixed maturities with a carrying value of $17.7 million. During the eight months ended August 31, 2003, the Company paid dividends pof $45.0 million which had been declared in 2002. During 2005, the Company transferred unaffiliated investments, including accrued interest, to an affiliated company in exchange for other unaffiliated investments, including accrued interest. The excess of the cost basis of the assets received over the assets transferred of $1.0 million has been accounted for as a capital contribution. 10. OTHER OPERATING STATEMENT DATA Insurance policy income consisted of the following (dollars in millions):
Successor Predecessor --------------------------------------- ------------ Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Traditional products: Direct premiums collected.............................. $1,054.7 $1,039.1 $ 339.8 $ 830.9 Reinsurance assumed.................................... 144.9 159.2 63.6 124.7 Reinsurance ceded...................................... (105.3) (117.8) (42.8) (88.7) -------- -------- ------- ------- Premiums collected, net of reinsurance............. 1,094.3 1,080.5 360.6 866.9 Change in unearned premiums............................ .8 (1.1) (.2) (2.2) Less premiums on universal life and products without mortality and morbidity risk which are recorded as additions to insurance liabilities .. (706.5) (662.8) (211.9) (528.5) -------- -------- ------- ------- Premiums on traditional products with mortality or morbidity risk...................... 388.6 416.6 148.5 336.2 Fees and surrender charges on interest-sensitive products............................................... 308.1 334.8 115.9 302.2 -------- -------- ------- ------- Insurance policy income............................ $ 696.7 $ 751.4 $ 264.4 $ 638.4 ======== ======== ======= =======
The four states with the largest shares of 2005 collected premiums were California (15 percent), Florida (10 percent), Texas (8 percent) and Pennsylvania (6 percent). No other state accounted for more than 5 percent of total collected premiums. 44 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- Changes in the value of policies inforce at the Effective Date were as follows (dollars in millions):
Successor ------------------------------------------ Years ended Four months December 31, ended ------------------- December 31, 2005 2004 2003 ---- ---- ---- Balance, beginning of period..................................... $ 877.0 $ 988.7 $1,072.7 Additional acquisition expense............................... 2.6 3.4 2.3 Amortization................................................. (127.3) (127.8) (52.9) Balance sheet reclassifications.............................. - 30.8 - Amounts related to fair value adjustment of actively managed fixed maturities...................... 42.8 (18.1) (33.4) ------- ------- -------- Balance, end of period........................................... $ 795.1 $ 877.0 $ 988.7 ======= ======= ========
Changes in the predecessor's cost of policies purchased for the eight months ended August 31, 2003 were as follows (dollars in millions): Balance, beginning of the period............................................................. $ 555.1 Additional acquisition expense on acquired policies...................................... 1.6 Amortization............................................................................. (24.3) Amounts related to fair value adjustment of actively managed fixed maturities............ 4.5 Reinsurance transactions................................................................. 50.0 Other ................................................................................... (6.8) Elimination of Predecessor balance....................................................... (580.1) ------- Balance, end of period....................................................................... $ - =======
The discount rates used to determine the amortization of the cost of policies purchased averaged 6 percent in the eight months ended August 31, 2003. Changes in the cost of policies produced were as follows (dollars in millions):
Successor Predecessor --------------------------------------- ------------ Years ended Four months Eight months December 31, ended ended -------------------- December 31, August 31, 2005 2004 2003 2003 ---- ---- ---- ---- Balance, beginning of period.............................. $ 34.3 $11.1 $ - $ 737.5 Additions.............................................. 74.0 24.4 12.0 39.2 Amortization........................................... (8.0) (1.2) (.9) (117.2) Amounts related to fair value adjustment of actively managed fixed maturities............................. .1 - - .6 Elimination of Predecessor balance..................... - - - (660.1) ------ ----- ----- ------- Balance, end of period.................................... $100.4 $34.3 $11.1 $ - ====== ===== ===== =======
11. STATEMENT OF CASH FLOWS Income taxes received totaled $20.0 million in 2005; $27.1 million in 2004; $94.7 million in the four months ended December 31, 2003; and $22.3 million in the eight months ended August 31, 2003. 45 WASHINGTON NATIONAL INSURANCE COMPANY Notes to Consolidated Financial Statements ----------------------------------- 12. STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES) Statutory accounting practices prescribed or permitted by regulatory authorities for insurance companies differ from GAAP. The Company reported the following combined amounts to regulatory agencies (dollars in millions):
2005 2004 ---- ---- Statutory capital and surplus.................................................. $762.0 $776.0 Asset valuation reserve........................................................ 66.9 59.5 Interest maintenance reserve................................................... 111.5 92.4 ------ ------ Total...................................................................... $940.4 $927.9 ====== ======
Our combined statutory net income was $129.7 million; $141.4 million and $192.2 million in 2005, 2004 and 2003, respectively. Insurance regulators may prohibit the payment of dividends or other payments by our insurance subsidiaries to parent companies if they determine that such payment could be adverse to our policyholders or contract holders. Otherwise, the ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. Insurance regulations generally permit dividends to be paid from statutory earned surplus of the insurance company without regulatory approval for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or statutory net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. Any dividends we pay in 2006 will require regulatory approval. During 2005 and 2004, the Company paid cash and non-cash dividends to its parent totaling $85.0 million and $126.0 million, respectively. Risk-Based Capital ("RBC") requirements provide a tool for insurance regulators to determine the levels of statutory capital and surplus an insurer must maintain in relation to its insurance and investment risks and the need for possible regulatory attention. The RBC requirements provide four levels of regulatory attention, varying with the ratio of the insurance company's total adjusted capital (defined as the total of its statutory capital and surplus, AVR and certain other adjustments) to its RBC as follows: (i) if a company's total adjusted capital is less than 100 percent but greater than or equal to 75 percent of its RBC (the "Company Action Level"), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position; (ii) if a company's total adjusted capital is less than 75 percent but greater than or equal to 50 percent of its RBC (the "Regulatory Action Level"), the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be taken; (iii) if a company's total adjusted capital is less than 50 percent but greater than or equal to 35 percent of its RBC (the "Authorized Control Level"), the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (iv) if a company's total adjusted capital is less than 35 percent of its RBC (the "Mandatory Control Level"), the regulatory authority must place the company under its control. In addition, the RBC requirements provide for a trend test if a company's total adjusted capital is between 100 percent and 125 percent of its RBC at the end of the year. The trend test calculates the greater of the decrease in the margin of total adjusted capital over RBC: (i) between the current year and the prior year; and (ii) for the average of the last 3 years. It assumes that such decrease could occur again in the coming year. Any company whose trended total adjusted capital is less than 95 percent of its RBC would trigger a requirement to submit a comprehensive plan as described above for the Company Action Level. The 2005 statutory annual statements filed with the state insurance regulators of each of our insurance subsidiaries reflected total adjusted capital in excess of the levels subjecting us to any regulatory action. 46 -----END PRIVACY-ENHANCED MESSAGE-----